There are different diagrams that you can use to explain 0ligopoly markets.
It is important to bear in mind, there are different possible ways that firms in Oligopoly can behave.
1. Kinked Demand Curve Diagram
In the kinked demand curve model, the firm maximises profits at Q1, P1 where MR=MC. Thus a change in MC, may not change the market price. It suggests prices will be quite stable.
The kinked demand curve makes certain assumptions
- Firms are profit maximisers.
- If one firm increases the price, other firms won’t follow suit. Therefore, for a price increase, demand is price elastic.
- If one firm cuts price, other firms will follow suit because they don’t want to lose market share. Therefore, for a price cut, demand is price inelastic.
- This is how we get the ‘kinked demand curve
However, the kinked demand curve has limitations
- It doesn’t explain how the price was arrived at in the first place.
- Firms may engage in price competition.
Collusive Oligopoly
If firms in oligopoly collude and form a cartel, then they will try and fix the price at the level which maximises profits for the industry. They will then set quotas to keep output at the profit maximising level.
The price and output in oligopoly will reflect the price and output of a monopoly. The Quantity Qm will be split between the firms in the cartel.
When it comes to oligopoly we can also bring into play game theory. This looks at how firms decisions depend on how other firms react.
Price war
In the example below, the best outcome for both firms is (a) $40, $40. However, if one firm cuts prices it will temporarily see higher profits $60 rather than $40. But, the other firm will immediately want to respond by cutting prices too, in which case they will both end up at just $3, therefore there is clear incentive to keep stable prices
However, when prices are stable, if one firm cuts prices (starts price war) it will see profits rise to $60. However, the other firm who keeps prices high will lose market share and get zero profits. Therefore, the firm who loses out will almost certainly retaliate and the outcome will move to (d) with both firms just making $3 profit. Therefore, there is a strong incentive to avoid price war.
Another way of displaying this game theory is though the matrix.
The outcome will effectively be the same
- If firms are competitive and they set low price -they will both make £4m.
- If they collude and set high price, then they will both double their profits and make £8m.
See more at Game Theory
Economies of scale for Oligopolies
Oligopolies may benefit from economies of scale. This enables lower average costs with increased output. FIrms in oligopoly producing at Q1 achieve lower prices of AC1.
Efficiency of firms in oligopoly
- Larger firms can benefit from economies of scale – lower average costs – which might outweigh other inefficiencies.
- Allocative efficiency? Not clear but firms operating under kinked demand curve may end up setting price higher than marginal cost. Also, firms able to successfully collude will set prices higher than MC. If oligopolies are competitive then prices will be lower and more allocative efficient.
- Dynamic efficiency? Firms in an oligopoly have profits they can use for investment in new products. Also, competitive pressures encourage them to innovate.
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